Stock Chartist

Commentary and recommendations about the stock market, sectors and individual stocks from a chartists perspective. Observations are based on the belief that "at their core, fundamentals are subjective but momentum is fact."

Post navigation

August 8th, 2013

The debate about portfolio management centers on whether one needs to “predict” or “react” for good performance. The professionals settle that for themselves by claiming that since no one can predict the future, the best anyone can do is to diversify into many different asset classes (i.e., equities, fixed income, commodities, currencies, domestic and foreign, income and growth, large and small capitalization). Economists like John Mauldin fall into this camp. He and other perma-bear economists have been seeing top for most of the last 10-15% of the market’s move. Mauldin recently wrote:

“This is a terrific time to take some profits and diversify away from the growth-oriented risk factors that dominate most investors’ portfolios. Instead of concentrating risk in one asset class or one country, investors can boost returns and achieve more balance by taking a global view, by broadening the mix of core asset classes, and by weighting those return streams to achieve balance across potential economic outcomes (rather than trying to predict the future) …..

broadening this mix of core assets – so that you have some element of your portfolio that responds positively to every potential economic season – and managing the relative allocations to each economic scenario may be your biggest opportunity to add value in the investing process. You have a lot to gain from diversifying as broadly as possible, eliminating unrewarded costs, reducing your reliance on equity risk, and reining in the emotional mistakes that often lead investors to dramatically underperform.”

What these portfolio managers don’t understand is that one doesn’t necessarily have to predict where the market will be next week, next month or next year. They claim that the only way to protect a portfolio against uncertainty when funds need to be withdrawn is to allocate assets among different classes based on today’s predictions and then rebalance periodically. But an alternative approach is to aim for the highest returns while at the same time reacting and responding to abnormal and unexpected volatility immediately after it occurs.

In the previous article about the “Ultimate Buy-and-Hold Strategy” , the basic premise was that by assembling a specific mix of asset classes for a very long time (actually, 42 years) you would have reduced the volatility of a portfolio without significantly and not reduced its return. However, nearly everyone would agree that, looking back with the benefit of hindsight, it would have been wonderful to have had the foresight to assemble a portfolio in 1970 and hold it until today, or 42 years. But would that same approach produce the best results if you were to assemble the portfolio today, at the end of a 13-year secular Bear Market? Thirteen years hence would we be better off if we assumed today that the next 13 years would be more similar to the 1982-2000 Bull Market than either the secular Bear Markets of the 1970’s and 2000’s?

We can’t predict the future but the odds are that the next 13 years won’t be even similar to the past 13 years. Using the same data as Merriman’s, the “Buy-and-Hold” portfolio management approach delivers much different results had the portfolio started at different points and had different end dates? As an alternative test, four hypothetical $200,000 portfolios were split into two parts, 60% in equities and 40% in fixed income, and rebalanced annually. The annual returns since 1970 for equities and fixed income securities came from the St. Louis Federal Reserve Bank. The four test portfolios were:

1970-2012 (the 42 year “buy-and-hold” base case),

1982-1999 (the last 17 year secular bull market),

2000-2012 (the current 12-year secular bear market) and

1970-1982 (the previous 12-year secular bear market).

There’s no question that, regardless of when the Portfolio was originally created, the 60/40 blended portfolio would always have been less volatile (as measured by the standard deviation of the portfolio’s annual change in value) than a 100% stock portfolio but more volatile than a 100% fixed income portfolio (click on images to enlarge).

But what is also true is that at end of the holding period, your portfolio would be worth more if you had been 100% in stocks than if you had blended in a percentage of fixed income …. sometimes much more. As a matter of fact, if you had started your portfolio at the beginning of 1982 and held it somewhere close to the top of the Secular Bull Market when the Tech Bubble burst, then your portfolio would have delivered an average annual 19.12% and wound up worth 166% of the 60/40% mix and 388% of a fixed income only portfolio. [Due to the spectacular decline in interest rates since the crash of the real estate bubble in 1977 – a trend that was as unprecedented as the secular bull market of the 1980-90’s – a fixed income portfolio would have out-performed an equity portfolio by 152% but neither delivered much more than 7.2% average annual return for the 12 years.]

As I see it, you shouldn’t have to pick a single goal. Are you wealthy enough to focus on “preservation” rather than “growth” in your portfolio? Are you so preoccupied in other matters than you can’t react to changes in trend of any particular asset class; remember, both the Tech Bubble burst and the Financial Crisis evolved over 6 months. Catch up on the major economic and business news once a week, make only incremental adjustments (i.e., not more than 10% of the portfolio at each decision) and you’ll be able to manage your portfolio. You don’t need to predict the future you only need to review, react and respond as changes demand. Portfolio management shouldn’t be day-trading but it can be more than just a “buy-and-hold” portfolio. You can generate growth as well as preserve your capital.